On July 6, 2011, a faint buzzing from your bedside table awakes you at 3 a.m. You ignore it. At 3:02, your Blackberry still vibrating, your iPhone, which you use for personal email and calls, starts in with the same high-frequency drone. At 3:03, your home phone starts ringing.
You’re a principal at a small, New York-based financial firm. The sudden cacophony means the worst has happened. In mid-May, the United States hit the debt ceiling: Because Congress failed to increase the debt limit, the Treasury Department could no longer issue new bonds to finance the United States’ deficit spending and to pay the interest on its existing debt. For a few weeks, Treasury and the White House were able to move money from one pocket to another to keep the country running smoothly. But the congressional bickering never abated, with Republicans insisting on the passage of huge, immediate spending cuts and a balanced budget amendment, and Democrats refusing to consider either—and certainly not to tie them to the debate over the $14.3 trillion ceiling.
Uncertainty hit the bond market, though not as hard as some expected: For a few weeks and for the most part, investors shrugged it off. But as the intransigence got worse and investors became more spooked, they started selling off Treasury bonds. Financial firms also quietly started converting investments into cash, seeking the absolute and unconditional safety that only dollars provide. The stock market slumped.
Weeks into the impasse, some Social Security payments stopped going out, causing American citizens to scream bloody murder. They barely noticed when, just before midnight on July 5, Treasury said it would start missing scheduled coupon payments on some bonds. Wall Street didn’t miss the announcement, though—hence your 3 a.m. wakeup call. The United States, to the shock and horror of investors around the world, sat on the brink of default. The world’s safest investment became the world’s most uncertain, tipping the markets into chaos.
You dash into your office and arrive by 5 a.m., finding a whole lot more than the Tokyo traders hanging out. Dozens of panicked associates are already there, flipping the TVs from CNBC and Bloomberg to C-SPAN and CNN. Analysts are reading The Hill and Politico, trying to figure out where the congressional negotiations, which lasted all night and have dragged on for months, now sit. You take a look at some of your company’s positions, and reaffirm to yourself that you are in good shape, at least on paper: solidly profitable, light on crummy assets, and carrying a considerable cushion of cash and some foreign currencies. But you receive the first of a few bad calls at 6 a.m.
Foreign investors are spooked, and they’re dumping Treasury bonds—billions of dollars’ worth. They had been selling them off for weeks, of course, possessing much less stomach for the idiocy of the U.S. political system than you and your fellow Americans. But now, investors in Asia and Europe are practically using tractors and pitchforks to move the bonds onto the markets. You and your fellow principals meet: Will the bond market finally force Congress to act? Will this sell-off prove temporary? Should you buy what everyone else is terrified of? Should you all be worrying about hunkering down and battening the hatches and hoarding cigarettes for the barter economy?
You leave that issue aside for the moment. You know, from your experiences in 2008, to keep a close eye on the $ 12-trillion “repo market.” You rely on it: Every night, your firm takes hundreds of millions of dollars of low-risk securities and, in essence, swaps them for cash on that market. That helps you maintain your balance sheet and provides your trading partner with a bit of income. Now, repo lenders are asking for more collateral for their cash, imposing a “haircut” on Treasury debt and agency debt, such as the bonds issued by Fannie Mae. The repo markets are again threatening to seize.
But by 9 a.m., you are onto other worries. Your firm had used Treasurys to help finance a big investment in emerging markets. Given the foreign sell-off, those Treasurys, once as close to cash as any investment came, are now worth less. The other side of the deal wants you to cough up actual cash to make up the difference. That means that your firm will have to sell off some holdings into a very bearish market in order to keep the investment. It is going to hurt your bottom line. And you imagine similar calls happening across the financial system.
At 10 a.m., you turn your attention to money-market funds—low-risk investment pools that offer stable-value shares with small returns. Such funds provide a lot of short-term liquidity for businesses. They also hold a whole lot of short-term Treasury debt. You remember what hell broke loose when such funds went on the fritz in 2008. Just one fund “broke the buck,” essentially repricing its dollar shares at 97 cents. That caused at a $500 billion run on all money-market funds. A possibility predicted by J.P. Morgan analyst Terry Belton months before, you hear a rumor that a big money-market fund carrying a lot of Treasurys might have to break the buck this time too, and frightened investors are pulling out and demanding their money back.
Within 72 hours, Congress has a deal on President Obama’s desk, raising the ceiling to $16 trillion in exchange for balanced budgets to take effect in fiscal-year 2015 and some serious cuts now. Treasury starts issuing new bonds and making all payments on existing ones. But the market panic requires the Federal Reserve to reboot its emergency programs, disrupts the housing market, permanently raises the United States’ borrowing costs, reshapes the world bond market, and shaves more than a percentage point off GDP growth—enough to throw the economy back into recession. Globally, investors no longer consider the dollar the reserve currency of choice.
You wish you’d just never gotten up that morning.